In Search of Optimal, Equal Monetary Policy

The Fed is listening. In a recent blog post, we analyzed a brand-new database which Fed staff have constructed to capture distributional wealth effects across the U.S. economy. Now, we turn to a brand newpaper from the president and staff of the Federal Reserve Bank of St. Louis that not only recognizes the distributional impact of monetary policy – a Fed first – but tries to do something about it. The paper proposes an “optimal” monetary policy based on a complex model with several uncertain assumptions, no conclusion about whether it would work in concert with a still-huge Fed portfolio, and nothing more than a theoretical hypothesis. Still, it’s a start.

How Optimal, Equal Might Work

For all one might disagree with aspects of this paper, its fundamental contribution is to reject representative-agent hypotheses of monetary policy – which unsurprisingly dispute distributional impact – in favor of heterogeneous actors viewed in terms of income, wealth, and consumption equality. We have done so before, noting the failures of aggregate data that Paul Krugman more colorfully described: “If Jeff Bezos walks into a bar, the average wealth of the bar’s patrons suddenly shoots up to several billion dollars – but none of the non-Bezos drinkers has gotten any richer.”

As outlined, a nominal-GDP monetary policy attempts to smooth GDP across an individual’s life cycle to reflect the natural transition of Americans from younger, poorer, debt-laden men and women to the middle-aged level of presumed comfort on to later-in-life periods of lower income and declining wealth. Equality-oriented optimal monetary policy is then premised on price levels, a sharp departure from the inflation-level focus of the Fed in recent years. The price level (defined by a new approach also crafted by this paper’s authors) is then set counter-cyclically to ensure that the real interest rate is always being pressed towards the neo-Keynesian neutral rate. This is said then to result in stable nominal GDP that reduces inequality. As real shocks occur, policy pushes back to the neutral rate via nominal GDP. Recurring shocks alter nominal GDP, inflation moves higher as part of the counter-cyclical price adjustment – in short, the economy runs hot for a while asJanet Yellen considered towards the end of her Fed term.

Possible Optimal Pitfalls

Score a big one for the St. Louis Fed on the path to optimal, equal monetary policy. But, as its authors readily acknowledge, this paper is premised on a simple, stylized model based on a lot of income inequality – that would be us – and a large private-sector credit market – ditto. Thereafter, analytical questions abound.

First, the model starts all actors at the same point and then varies factors such as productivity to ascertain life-cycle equality. As Piketty made clear, inequality is a cumulative cycle or, as others have determined, inequality economics are characterized by inter-generational immobility in which children of the rich start better off than everyone else and children of the poor start farther behind where their parents began a generation ago. It is not clear to us if the model would derive its optimal results if inequality began at the outset instead of increasing over the life-cycle absent its new monetary-policy counter-pressure.

Second, and even more fundamentally, aiming monetary policy at a stable nominal GDP may be less equalizing than the paper hopes because GDP is a lot less equal than the paper acknowledges – see here for a discussion of why.

Third, this model is extremely abstract. It recognizes U.S. income, wealth, and consumption inequality by running its life-cycle models by inequality data (about which we have some quibbles), but it does not ponder the question of how its policy would be implemented. This may seem like a second-order question, but it’s an immediate issue because Fed post-crisis policy has demonstrably made U.S. income and wealth inequality worse all on its own. See here and other blog posts for an extensive discussion of how quantitative easing backfired with minimal long-term output impact but considerable, direct benefits to equity valuations that then enrich portfolios comprised of financial assets held – as new Fed data again demonstrate – largely by the very rich. Ultra-low interests also exacerbate income inequality, especially in the absence of meaningful, distributed output growth.

Thus, if the Fed sought to implement this optimal policy through quantitative easing or even if it just perpetuated its plans now to hold close to $4 trillion, it’s at best unclear if optimal policy would make an equality dent. Similarly, if “optimal” policy went below low interest rates into ultra-low territory, still more equality damage would ensue.